Question

Warmth (Pty) Ltd, a leading retailer of plush Sherpa throws, purchases its inventory on credit from Continental Luxury Ltd. Warmth (Pty) Ltd has an overdraft facility at Winter Bank Ltd that accrues interest at 16% per annum. Continental Luxury Ltd offers terms of 2/10 net 60. Calculate the approximate cost of giving up the cash discount and determine whether the discount should be taken or not.

Answer 1

Case 1: If the payment is made immediately ( on 1st day of credit period)

Assuming 365 days in a year.

Given in the Question that interest accrues on the Overdraft facility is 16% per annum

Interest cost for 60 days = 16% /365*60

= 2.63%

If we delay the amount upto 60 days means we can save 2.63 % interest. Where as if we pay the amount within 10 days we are getting only 2% Discount.

Net interest cost = 2.63% - 2% = 0.63%

We have to bear 0.63% interest burden for availing the discount.

Hence it is better to pay the amount on 60th day and not to avail the discount from the supplier.

Alternative method: Case 2:Assuming that amount is paid on 10th day to avail the discount.

Interest cost for 50 days = 16% /365*50

= 2.19%

Net interest cost = 2.19% - 2% = 0.19%

We are bearing extra interest of 0.19% for 2 months.So we should not avail the discount.

We should prefer to pay the amount on 60th day and not to avail the discount.